Why Most Option Traders Lose

A common mistake that plagues many option traders is choosing
"lottery-ticket" options that have big potential payouts, but minimal chance of
success.

I taught trading in India for well over a year in 2010-1011 at the Online
Trading Academy in Mumbai. I trade in nearly every asset class and also
encouraged my students to do the same in order to take advantage of many market
opportunities.

When I asked my students in class, "How many of you trade options?" I usually
got several hands raised. However, when I asked how many of them were profitable in
trading them, most hands went down.

In courses I taught for relationship managers and brokers, I also asked how many
of their clients were trading options successfully. To my amazement, I did not
find too many profitable options traders in India. This made me look further
into the strategies being employed by those traders to see if there is something
they were doing wrong and if I could offer a solution.

One such mistake made by novice traders in the option markets is trying to
trade deep-out-of-the-money options in order to buy cheap premium. This strategy
is often referred to as a "lottery ticket," as the payouts can be great, but the
odds of winning are extremely slim.

When trading, we want consistent wins in any market we trade. Most successful
traders became that way from winning on a regular basis and not gambling with
poor odds to try to make a big win.

Let's examine that "lottery ticket" trade from a historical perspective and compare it to one that had a
higher probability of making money. On October 19, 2011,
the Nifty had retreated from a supply zone near 5150.

A trader who had wanted to take advantage of the potential bearish drop could have bought puts. They would have profited from a drop in price as well as an increase in volatility by doing this. On that date, the open interest looked like this:

5200 puts = 11, 86, 750

5100 puts = 41, 88, 900

4800 puts = 83, 04, 000

Looking at the high open interest, it appears that many traders were buying
their lottery tickets at a strike price of 4800 on the Nifty. But was—or is—this the
smartest thing to do?

Most traders buy this option because of the low premium cost. Looking at the
different options, the cost to buy the 4800 put was only Rs. 217.50 (there are
50 shares per contract).

Click to Enlarge

This was a lot cheaper than the 5100 puts (Rs. 2645) or the 5200 puts (Rs.
5437.50). But, at the time, was it the best trade?

Article Continues on Page 2

|pagebreak|

Most option traders ignore the Greeks in trading. The Greeks are
measurements of risk in options trading. They can also be used to gauge
potential profitability in the trade.

Assuming the Nifty was trading at 5116, if the Nifty were to move to
5000 at the expiration of October 25, 2011, the trader who bought the 4800 put would
profit about Rs. 298 (Rs. 257 per point move in the Nifty). Not bad for an
initial investment of only Rs. 217.

But wait...holding to expiration would also have cost you time value. You would
have lost about Rs. 86 per day in time value and that would have erased all of your
profits in the trade!

Buying the 5100 put would have cost more, but the larger Delta would have compensated for the loss
in time value. The same movement in the Nifty would have profited Rs. 2744, (Rs. 23.66 per
point move in the Nifty), a nice gain for a Rs. 2645 investment. Even after time
had eroded, there was still a profit of about Rs. 1300.

In this same example, the last trader who bought the 5200 put had to pay the most, but got to
participate more in the movement of the Nifty. They received Rs. 38.62 for every
point the Nifty fell. This would have translated into a gain of about Rs. 4480. Even when
time eroded, they would have been left with a Rs. 2574 gain!

The 5200 put initially had intrinsic value of 84 points or Rs. 4200 per
contract. You would have gotten that back when you sold or at expiration. At the time, I thought of it
as a deposit to make more money in the movement of the Nifty. Removing that
intrinsic value, you would have been only paying Rs. 1237 in time value to make Rs. 2574.
That 208% gain would have been a lot better than gambling on a cheap option only to have made
nothing!

There are a lot of things to learn about trading options.

Trade smart; it isn't gambling, it's speculation with a high probability of
success when done right.